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Abstract
Financial institutions frequently offer low introductory interest rates to entice individuals to open and use credit accounts with their firm. This paper examines the possibility of earning arbitrage profits by taking advantage of these special offers. We develop a formula to measure the profit potential from undertaking credit card arbitrage and identify conditions conducive to profitable and unprofitable arbitrage. In addition, we examine the sensitivity of the arbitrage transaction to changes in interest rates, interest rate levels, and fees. Finally, we examine the impact of credit card arbitrage on the credit rating of the arbitrageur.
© 2008 Academy of Financial Services. All rights reserved.
JEL classifications: G21; H31
Keywords: Credit cards; Arbitrage opportunities; Bank profitability; Consumer debt
1. Introduction
Many banks offer credit card balance transactions with low, or no interest rates. The balances can generally be transferred to pay off another card or transferred directly into a checking account. These introductory low interest rate offers are intended as an enticement for individuals to open an account with the financial institution or to transfer their balance to a lower interest rate credit card. The low interest rate offers generally apply to an introductory period and have an up-front fee. The introductory time period is typically anywhere from three months to eighteen months. Other promotions offer the introductory rate until the balance is paid off. Still other promotions offer perquisites, such as frequent flier miles, for each dollar transferred to their affiliated credit card. Some promotions require the cardholder to make a purchase to receive the special rate.
Although the credit card offers are intended to attract more credit card business for the bank, they may also provide the customer with the potential to earn an arbitrage profit. To earn an arbitrage profit, an individual takes a cash advance against the credit card and deposits the funds received into an FDIC insured money market account. An arbitrage profit is earned if the interest earned on the money market account exceeds the cost of funds related to the credit card cash transfer.
Low introductory rates serve as a loss leader for the financial institution. Banks profit from these offers in several ways. Some of the offers are made on accounts with an annual fee....